The Real Estate Market
Generally speaking, the real estate market is in the "denial" phase of its valuation cycle. The next phase is often a difficult one--which makes us remember why we were in denial! You can be sure that with retail sales flat or declining, retail projects won't prosper. Likewise, the death of the dot-coms and layoffs in other industries will leave a hole in the income statements of many office buildings. This means many types of real estate will suffer in the coming months.
However, self-storage still appears to be experiencing increasing rates (albeit, at a little slower pace) and steady occupancies. This means a continuance of relatively consistent cash flow for most self-storage properties. With other sectors beginning to perform subpar, investors are looking for real estate with predictable cash flow and a possibility to improve. For example, in most types of real estate, foreclosures are beginning to appear. The following chart shows the relative performance of self-storage early in the economic slowdown. This information on conduit loans for October 2001 shows the default rates for different types of real estate.
As you can see, self-storage has a very impressive record--so far. These statistics are important for three reasons: First, the low numbers show the strength of the industry in light of the economy. They also prove self-storage demand is not born of a "boom and bust" cycle. While the demand was positive in the prosperous times, it was not excessive because people don't rent self-storage for the same reasons they would, say, buy a new car.
Second, the mere fact self-storage is even listed is very important. The industry has now earned its wings as a product type deserving of special consideration. It had not been that way in the past down-cycle, but investors are sure to take notice of self-storage's stability this time around.
Last, but not least, the comparison looks great. For example, office properties have a delinquency rate three times that of self-storage; multifamily properties have a rate at five times; industrial properties, eight times; and hotels, 16 times. With self-storage cap rates being about 20 percent higher than those on industrial properties, this information is sure to be an attention-getter for potential buyers. Combined with stock market challenges, a 10 percent unleveraged cash return looks good to an investor of any type.
When financing is cheap (and is it ever!), pricing for solid cash flow tends to be strong. The Federal Reserve has really given a bonus to self-storage owners and potential buyers this past year. While it appears rates will remain low in the short term, it is uncertain whether they will be higher by the end of 2002. Neal Gussis of Beacon Realty Capital has a study that shows it is a rare year that mortgage rates don't move 2 percent in one direction or another.
But for the time being, sellers can still get great rates. The bad news is lenders are getting much more selective about product quality, and this situation is unlikely to change in a period of uncertainty and generally rising delinquencies. Also, while many lenders still remain on the sidelines, banks are cautiously lending, particularly to known buyers and on local projects with conservative loan-to-value ratios. In sum, getting a loan has become more difficult but cheaper. This impacts the buyer market because the bankers want experience, net worth and quality projects.
Despite the positive aspects of the self-storage industry, cap rates have not come down much, if at all, because of the general level of uncertainty in the economy--which means prices go up. Great properties in perfect locations still may have sub-10 cap rates. Simply good projects in good locations fall into the 10 cap-rate range, and all the others have cap rates of 11 or higher. The major impact on pricing in uncertain times is how speculative cash flow is viewed by potential investors.
Let's say a project is 80 percent occupied and has a good history of higher occupancy, i.e., 85 percent to 90 percent. In the past, many potential investors would have considered the lower occupancy as potential for future additional cash flow (the "glass is half full"). Today, many now look at this same situation as a "glass is half empty" scenario and are not willing to pay very much for potential income.
This same attitude applies to expansion ground, potential rent increases and other normally positive attributes. So while pricing is excellent as it relates to actual cash flow, potential cash flow is sharply discounted. Most buyers are now calling potential cash flow "blue sky" where, in the past, they talked about a property ready to "blossom." The general rule is to base pricing on 12 months of trailing income (the preceding 12 months), with no look toward income increases except in extreme circumstances. (For a primer on valuation, visit the Inside Self-Storage online archive or www.selfstorage.com.)
Although the 2002 real estate market may have significant challenges, self-storage will reveal itself to be a relatively safe haven in an otherwise choppy environment. Here are some other things to expect in the upcoming year:
- There will be fewer buyers, but they will be serious buyers.
- Potential buyers will be quite picky about the quality of projects and the certainty of cash flow.
- Every buyer will have several good options, so sellers must professionally market their properties with attractive, definitive and accurate information.
- Sellers will need to price their facilities in a reasonable range to attract serious buyers. They will not be successful in looking for the "greater fool" when investors are still licking their wounds from the dot-com fallout. This does not mean to sell at a bargain price, merely a fair market price.
- Sellers will have to be patient, as finding the right buyer can take time. Buyers are also taking more time to evaluate properties. They may have only recently become interested in self-storage because their former favorite real estate types--office, retail, etc.--are experiencing tough times. Thus, their move up the learning curve may be slower.
While 2002 may not be the greatest year for real estate, the self-storage industry has some real aspects that will keep it strong during the slowdown. The long-term benefit is more investors will finally see the value of self-storage.
Michael L. McCune has been actively involved in commerical real estate throughout the United States for more than 20 years. Since 1984, he has been owner and president of Argus Real Estate Inc., a real estate consulting, brokerage and development company based in Denver. In January 1994, he created the Argus Self Storage Real Estate Network, now the nation's largest network of independent commercial real estate brokers dedicated to buying and selling self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.
TREPP Report on Delinquency for Conduit Loans
Oct. 25, 2001
|Property Type||Percentage of Total|
|Overall Delinquency Rate||1.07|